Thoughts on Subordination Agreements
It often happens that there is placed before the auditor, in support of a contention that there is no irregularity or likelihood of financial loss to the undertaking or to its members or creditors, a document that is referred to as a "subordination" agreement.
This is an agreement by a substantial creditor or substantial creditors (usually, but not necessarily, shareholders in the client company) whereby they bind themselves either indefinitely, or for a limited period, and either unconditionally or subject to specific conditions, not to claim or accept payment of the amounts owing to them until the happening of a particular event, for example, the restoration of the finances of the undertaking to a position of solvency, or the payment of all other creditors.
Subordination agreements may take many forms. They may be bilateral, that is, between the undertaking and creditor. They may be multilateral and include other creditors as parties. They may be in the form of a stipulatio alteri, that is, for the benefit of other and future creditors and open to acceptance by them. The subordination agreement may be a term of the loan or it may be a collateral agreement entered into some time after the making of the loan.
The legal character and effect of such an agreement were described as follows by Goldstone J.A. in the Carbon Developments case[i]. ‘Save possibly in exceptional cases, the terms of a subordination agreement will have the following legal effect: the debt comes into existence or continues to exist (as the case may be), but its enforceability is made subject to the fulfillment of a condition. The condition usually being: The subordination referred to shall remain in force and effect for so long only as the liabilities of Y exceed its assets, fairly valued, and shall lapse immediately upon the date that the assets of Y exceed its liabilities.
Such a condition is set out in the Memorandum of Agreement dated 20 October 2009 between Company A and Company B.
Para 4 is as follows:
‘The subordination referred to in 2 shall remain in force and effect for so long only as the liabilities of Company B exceed its assets, fairly valued, and shall lapse immediately upon the date that the assets of Company B exceed its liabilities and shall not, except by further agreement in writing, be reinstated if thereafter the liabilities of Company B again exceed its assets, provided that the liabilities of Company B shall be deemed to continue to exceed its assets unless and until the auditor of Company B has certified in writing that he/she has been furnished with evidence which reasonably satisfies him/her that the liabilities do not exceed the assets’.
[i] Ex parte de Villiers & Another NNO: In re Carbon Developments (Proprietary) Limited (in liquidation) 1993(1) SA 493(AD).
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